How to Tell a Good Captive Insurance Company from a Sham—Part 6

By: Sean King, JD, CPA, MAcc

Principal & In-House Counsel, CIC Services, LLC

Question: If a business owner lacks “sophistication” regarding insurance and relies on a captive manager to operate a captive insurance company, is this evidence of a sham?

Welcome to part 6 of my series, addressing naïve and misguided criticisms of small captive insurance companies and the small and mid-market companies that rely on them as part of their risk management program.  As a refresher, I have noted that there is growing concern among regulators, the IRS, and captive insurance professionals that too many captive insurance companies, especially the small 831(b) variety, lack economic substance—that is, that they are shams constructed for the purpose of avoiding taxes rather than for real insurance and risk management reasons.  The criticism is that some captives are formed to achieve tax objectives while failing in substance to provide any meaningful insurance or risk management benefits.

While we share this concern, many of the guidelines offered up by the IRS or others to help the public differentiate good and bad captives (and good and bad captive advisors), are mostly useless.

Consider this statement put forth as evidence of a sham transaction by the IRS in their recent “Dirty Dozen” release.

“[captive managers] manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance…”

Let’s take this piece by piece, starting with, “manage the entities’ captive insurance companies year after year.”  All captive insurance companies are managed “year after year,” and the IRS knows this.  They have to update their underwriting and actuarial pricing of policies every year.  They have to file their tax returns every year.  Most are audited every year.  They have to have a board meeting…(you guessed it) every year.  Most domiciles require companies – particularly small and mid-market companies without a large risk management department – to have a licensed captive manager manage their captive and interface with the domicile’s regulators.

Note that most small and mid-market business owners have no particular skill in such things.  For them to do these things themselves, as opposed to paying competent professionals “hefty fees” to do so, would be the very height of irresponsibility.  If anything, it’s the FORMER that would evidence a sham.  The latter is, in fact, evidence of the opposite:  That the business owner wanted to own a legitimate insurance company overseen by competent professionals.

After all, don’t such businesses regularly outsource similar professional services?  Don’t they hire CPAs to do their taxes, insurance brokers to assist with risk management, health insurance administrators to run their health plans, retirement plan administrators to run their 401(k)s, payroll companies to do their payroll, and other service providers for various other tasks “year after year.”  And don’t they pay them “hefty fees?”  Of course they do.  Doing otherwise would be irresponsible in most cases.  How does hiring competent professionals to assist in areas where the business owner is not an expert evidence a sham?  It doesn’t.

Second, let’s address, “hefty fees.”  This statement implies that the work performed by captive managers isn’t valuable.  It’s no surprise that risk managers for large corporations are well compensated.  Risk management, risk mitigation and insurance are complex and require significant expertise.  Are we to believe that it’s somehow improper for small businesses to compensate independent captive managers to provide the same services that Fortune 1000 companies hire employees to do?  In many ways, independent risk managers servicing small and mid-market companies face greater challenges than their Fortune 1000 brethren because the former serve many different companies across many different industries, versus working for one corporation.  My experience (and the experience of my contacts in the industry) is that captive management fees are in line with other service industries requiring specialty expertise (legal, accounting, insurance brokers, etc.).  And, if anything, these fees have DECLINED REMARKABLY in recent years thanks to increased competition among captive providers.

Finally, we come to, “assisting taxpayers unsophisticated in insurance…”  It really goes without saying that this statement has broad (and obviously absurd) implications.  Let’s plug and play a few examples:

• CPAs assist taxpayers [business owners] unsophisticated in filing tax returns…
• Payroll companies assist business owners unsophisticated in processing payroll…
• Attorneys assist business owners unsophisticated in legal matters…
• Property and casualty brokers assist business owners unsophisticated in risk management…
• The list goes on…

Does the IRS realize that small and mid-size business owners hire experts (outsource) to help them operate their businesses?  Ironically, many large corporations outsource too.  One can’t help coming away feeling like the IRS thinks small business owners are simpletons.

And, this brief exercise in the absurd brings us full-circle to answer the question, “If a business owner lacks sophistication regarding insurance and relies on a captive manager to operate a captive insurance company, is this evidence of a sham?”  Clearly, the answer is, “NO!”

As can be seen, this supposed evidence of a bogus captive falls flat.  It is far more helpful to provide meaningful descriptions of illegitimate captive arrangements.  With that in mind, here are some specific characteristics of bogus captives:

–Little or no attention paid to the risk management benefits a captive affords its owners and insureds

–Captive managers are not licensed

–Captive managers misrepresent captives by focusing only on tax benefits

–FAILING to engage competent professionals (captive managers, actuaries, lawyers, etc.) to ensure that the captive is managed properly, insurance policies are drafted and priced properly, etc.